Financial markets

Bonds and QE

Wrong direction

WHEN the Fed announced a new round of quantitative easing on November 3rd, part of the aim was to drive down bond yields in the medium-term part of the yield curve. One of the main arguments for QE is that it is simply a natural extension of conventional Fed policy; yields are so low at the short-end of the curve that the Fed has to intervene in the bond markets to have any impact at all.

But look at the chart. Ten-year yields are significantly higher than they were at the start of November. Now the answer might seem obvious. Investors are worried that money-printing will create inflation. But we can measure inflation expectations with the help of the index-linked bond market or TIPS. The gap between conventional and index-linked yields should represent inflation expectations. At the start of November, the expected inflation rate, measured by the 20-year TIPS issue, was 2.4%; it is still the same today. No shift at all.

Short-term measure of inflation have also moved in the wrong direction (in terms of explaining the yield move). The latest consumer price index numbers form the US were quite soft. Commodity prices have been dropping over the last week and gold is $100 or so down from the peak. The fact that China is planning to tighten policy is seen as bad news for commodities.

Nor is it plausible to say that bond yields are rising because investors have become less risk-averse. The Irish crisis should, if anything, have caused a flight to safety into Treasuries; equity markets were, until yeterday, struggling over the last week or so.

In addition, the issue is clearly not just about America or QE, since gilt yields have also been rising (see chart). A further round of QE in Britain is not impossible, but far from certain after better-tna-expected growth numbers and worse-than-expected inflation figures.

It is a little bit of a mystery; Simon Derrick, a strategist at Bank of New York Mellon, is also at a loss to explain the shift and thinks it might reverse shortly.

The year is 2012....six months earlier the fed announced QE5....now inflation = 26% and 5 year rates = 29%. The fed just met with Mr. Obama and congress to suggest a very old concept....cutting spending in order to balance the budget and lower rates.

Nonsense. QE is not failing. What is failing is the Economist's understanding of the purpose of so-called Quantitative Easing. (I hate that word. Lets call it the old fashioned term, used in all the textbooks - "printing money". Look it up!). The main purpose of 'QE' is NOT to reduce interest rates, or even keep them low, but to stimulate the economy by spending on employment creating activity. Both the Economist and the Fed and probably the latest generation of economists who probably were never taught monetary economics,per se, appear to have no real understanding of the purpose of 'printing money', which was well understood by Keynes, Friedman, and most text book writers until recently.

In fact part of the problem is the misuse of that idiot term. If you go to any standard textbook, you will see that the main purpose of government printing money is NOT to reduce interest rates (remember the 'liquidity trap' you were taught as an undergraduate - low interest rates in a recession are useless) but to spend on employment creating activity.

So why oh why do the journalists at the Economist perpetuate this nonsense that low interest rates right now are 'good'? In fact Minsky and the Austrian School argue that in a recession the risk free interest rate should be around 4 per cent to prevent a return to speculation and a misuse of funds.

The need for low interest rates? I think it is a story put around by the banks. And you know how guilty they are!

And to repeat a third time - do not use printing money (QE!) to keep interest rates below 4 per cent! Use it to spend on infrastructure or something which will stimulate the economy. Do you understand that, you useless idiots in the Fed and the Treasury?

Without any Quantitive Easyng the US dollar was very, very overvalued.

If, on top of it, you start printing more green paper in order to inflate away your debt, I wonder how on earth someone can be so stupid to join a "flight to safety into Treasuries" which yield nearly zero and run the risk of becoming dust in the not so distant future.

I bet my bottom dollar the Chinese, the Germans and the Brazilians, who now hold huge amounts of those "secure bills" are very, very itchy about that "security".

As far as I am personally concerned I am staying as far away from the US$ as the devil would stay away from a cross.

Ever consider that QE is causing disinflation via giffen behavior, low expectations of future income and higher relative prices of consumables creating uncertainty and increasing the demand for savings and liquidity, and inflated equity and assets prices making investment unattractive to the broader population?

US QE2 will not have as much impact, if any, on real economy as the first round, as economist here points out convincingly http://www.mindfulmoney.co.uk/2211/economic-impact/real-economy-the-lose.... QE in general tends to encourage appetite for risk and this second round is only going to lead to asset bubbles all over the place. Basically its based on the theory of ‘trickle down economics’ – made famous in our lifetime by Regan and Thatcher. Of course the latest experiment with this in the shape of QE is rather more, er..shall we say adventurous?, bold? Nah, its great big gamble, playing cards in the last chance saloon. Bernanke’s Op ed piece in the WSJ recently stopped all the pretence that it has anything difrectly to do with the real economy, real jobs, real lending for small businesses and real households. Once the markets have riden the asset bubbles, and they have burst, as they always do, I guess we can do QE all again and our illustrious, knowing policymakers’, with their penchant for learning about economics by studying miniature golf, can hock another few generations with their largesse. This market party will come to an end and real world will come crashing in for sure, its just mainstreet, real ordinary people will have pick up the bill, yet again. Having said that I do think US QE1 did have some positive impact on real economy, it was well structured and targeted and triggered some meaningful lending. I just think QE2 is ill-fated.

I may have it wrong and am willing to be put right, but it seems to me that when contributors write about QE they have the image of the Fed pumping in real money, notes and coins, (one contributor even called them greenbacks)into the economy. This, they think, causes inflationary trends, leads to the dollar devaluing and so, hopefully boosting exports. They are correct in those last assumptions but wrong about what QE is.

I think that quantitive easing means that the Fed buys bonds from the market and pays for them with digital money (credit entries in sellers' accounts).

These sellers, probably from overseas, do what they like with that electronic money. They don't have to put it back into the
U.S. economy and most likely don't.

As the world's currency exchange holder, America has to act more responsibly, first to her own citizens and second to the world at large. By taking the simplistic measure in printing the green backs to boost the nation's falling economy is but a means to an end in resolving her underlying economic,financial issues. At the same time she puts pressures on the rest of the world to resist the excessive inflows of the US dollars. Merely based on the privilege of being the world's currency exchanger and continuing to bear a rising national deficit,the American dollars are becoming 'banana' notes. Further, the emerging economies may be forced to take drastic actions to reduce the impact of unwanted dollars flowing into their coffers. An alternative monetary supply system is imminent and it could certainly undermine the frail economic system of the USA. The Rule of Equity applies.

I don't think QE2 is big enough to have a discernible effect on anything in particular when it has only been operating for two weeks.

But claiming that QE2 would work by reducing long-term interest rates was always backwards. The Federal Reserve stimulates the economy by increasing the spread between short-term rates and long-term rates -- usually by reducing short-term rates, but in the case of QE and QE2 by increasing the circulating money supply via the provision of reserve bank credit. To the extent QE2 stimulates the economy, we should see the spread between short & long increase, as it has been.

But it is probably just normal market fluctuations, as QE2 has barely begun, and isn't really that big anyway.

The printing of all this money, can only be done for 2 main reasons. 1. the world economy is producing too many commodities causing DEFLATION, and 2. the acute nature of the world slump, that the authorities are attempting to stave of a depression.
Of course, the ruling class will take whatever measures it needs to stave off a depression, but it will all be to no avail. The intervention of the international socialist revolution will save the day.
Workers unite!

The FED is going to continue QE until the dollar falls to the point where the US actually has a trade balance. Or a payments balance, if you prefer. Inflation will not become an issue until growth has resumed at a substantial rate, which will not be anytime soon, given the 7 year average recovery period for recessions induced by financial crisis. Those who are prattling on about the US inflating away its debt are projecting way too much of themselves into what they are saying.

The FED is the 800 pound gorilla in the room; Ben just doesn't want to state the above quite so boldly. If the Chinese stop holding down their currency, the QE will end much sooner. Otherwise, their efforts are going to become quite expensive to them.

If everyone found out tomorrow that the US was going to race into growth, we would see an increase in the 10 year yield, possibly back to levels of 6 or 7 per cent nominal, as the private sector looked to take on debt and invest in the future.
In an environment where yields are zero, it is difficult to tell whether an increase in long yields is due to:
1. an increase in growth expectations
2. an increase in inflation expectations
3. an increase in risk
But if QE is targeting 2-5 year yields, and if QE "works", then it should increase the forward rates of money from 5-10 years through higher growth expectations. That could outweigh the reduction in yield at the short end, lifting the nominal yield on the 10 year.
Paradoxically, good economic policy in the United States will probably be evidenced by increases in long term rates.

It may be plausible to say that bond yields are rising because investors have become less risk-averse inasmuch as corporate debt issuance, including high-yield debt, ie, junk bonds, has risen sharply in recent months.

frabrit wrote: "There are two 800 lb gorillas in the room. One is the QE2 and the other is China"

You should be more careful with your abreviations ! What if somebody reads your QE2 as "Queen Elizabeth II" ? With all the publicity about the fortcoming Royal marriage, etc. you may get into a real trouble ! :))

I've said this before & I'll say it again: QE2 is a clear case of "Too little, too late".

This half-hearted & paltry $600 billion is not going to make any dent in the recovery process. Maybe, just maybe, if the initial QE1 bailout was in the $2-2.5 trillion range, the economy could have been rekindled sufficiently by now & a further infusion of funds could have been avoided.

Desperate times call for desperate measures. It's a case of "All or nothing". The sooner the Feds & the Administration read the writing on the wall & do something effective, I see little hope for a recovery.

many parties in the bond market had WEEKS to load up on product to supply the Fed when they finally got into it w details....but ofcourse the transactions to date have been dwarfed by what the various players had ready to sell, ergo more sellers than buyers and prices fall (yields go up) - another aspect is that the Fed will not repo their bond holdings at market rates, so therefore being short has gone up in price, but since much of the bond market is about curve trades (being short bond X against being long bond Y), the net effect is that there are less bonds available for shorts to borrow, so less participation by institutional bond participants...again, that puts downward pressure on all bond prices (yields increase)